entity a is constructing a building and expects it to take 18 months to complete to 612446

Cash flow hedge of variable-rate debt using an interest rate swap

Entity A is constructing a building and expects it to take 18 months to complete. To finance the construction, on 1 January 2012, the entity issues an eighteen month, CU20,000,000 variable-rate note payable, due on 30 June 2013 at a floating rate of interest plus a margin of 1%. At that date the market rate of interest is 8%. Interest payment dates and interest rate reset dates occur on 1 January and 1 July until maturity. The principal is due at maturity. On 1 January 2012, the entity also enters into an eighteen month interest rate swap with a notional amount of CU10,000,000 from which it will receive periodic payments at the floating rate and make periodic payments at a fixed rate of 9%, with settlement and rate reset dates every 30 June and 31 December. The fair value of the swap is zero at inception.

On 1 January 2012, the debt is recorded at CU20,000,000. No entry is required for the swap on that date because its fair value was zero at inception.

During the eighteen month period, floating interest rates change as follows:

	Cash payments
	Floating rate on principal	Rate paid by Entity A
Period to 30 June 2012	8%	9%
Period to 31 Dec 2012	8.5%	9.5%
Period to 30 June 2013	9.75%	10.75%

Under the interest rate swap, Entity A receives interest at the market floating rate as above and pays at 9% on the nominal amount of CU10,000,000 throughout the period.

At 31 December 2012, the swap has a fair value of CU37,500, reflecting the fact that it is now in the money as Entity A is expected to receive a net cash inflow of this amount in the period until the instrument is terminated. There are no further changes in interest rates prior to the maturity of the swap and the fair value of the swap declines to zero at 30 June 2013. Note that this example excludes the effect of issue costs and discounting. In addition, it is assumed that, if Entity A is entitled to, and applies, hedge accounting, there will be no ineffectiveness.

The cash flows incurred by the entity on its borrowing and interest rate swap are as follows:

	Cash payments
	Interest on principal CU	Interest rate swap (net) CU	Total CU
30 June 2012	900,000	50,000	950,000
31-Dec-12	950,000	25,000	975,000
30 June 2013	1,075,000	(37,500)	1,037,500
Total	2,925,000	37,500	2,962,500

There are a number of different ways in which Entity A could calculate the borrowing costs eligible for capitalisation, including the following.

(i) The interest rate swap meets the conditions for, and entity A applies, hedge accounting. The finance costs eligible for capitalisation as borrowing costs will be CU1,925,000 in the year to 31 December 2012 and CU1,037,500 in the period ended 30 June 2013.

(ii) Entity A does not apply hedge accounting. Therefore, it will reflect the fair value of the swap in income in the year ended 31 December 2012, reducing the net finance costs by CU37,500 to CU1,887,500 and increasing the finance costs by an equivalent amount in 2013 to CU1,075,000. However, it considers that it is inappropriate to reflect the fair value of the swap in borrowing costs eligible for capitalisation so it capitalises costs based on the net cash cost on an accruals accounting basis. In this case this will give the same result as in (i) above.

(iii) Entity A does not apply hedge accounting and considers only the costs incurred on the borrowing, not the interest rate swap, as eligible for capitalisation. The borrowing costs eligible for capitalisation would be CU1,850,000 in 2012 and CU1,075,000 in 2013.

In our view, all these methods are valid interpretations of IAS 23, although the preparer will need to consider what method is more appropriate in the circumstances.

In particular, if using method (ii), it is necessary to demonstrate that the gains or losses on the derivative financial instrument is directly attributable to the construction of a qualifying asset. In making this assessment it is necessary to consider the term of the derivative and this method may not be appropriate if the derivative has a different term to the underlying directly attributable borrowing.

Based on the facts in this example, method (iii) appears to be inconsistent with the underlying principles of IAS 23 – which is that the costs eligible for capitalisation are those costs that could have been avoided if the expenditure on the qualifying asset had not been made – and is not therefore appropriate. [IAS 23.10]. However, it may not be possible to demonstrate that the gains or losses on specific derivative financial instruments are directly attributable to particular qualifying assets, rather than being used by the entity to manage its interest rate exposure on a more general basis. In such a case method (iii) may be a preferable treatment.

Note that these methods would not be permitted under US GAAP which prohibits the capitalisation of the gain or loss on the hedging instrument in a cash flow hedge. Instead, ASC 815 states that ‘[i]f the variable-rate interest on a specific borrowing is associated with an asset under construction and capitalized as a cost of that asset, the amounts in accumulated other comprehensive income related to a cash flow hedge of the variability of that interest shall be reclassified into earnings over the depreciable life of the constructed asset, because that depreciable life coincides with the amortization period for the capitalized interest cost on the debt.’¹ Whichever policy is chosen by an entity, it needs to be consistently applied in similar situations.